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Avoiding the Japan trap

China’s economy isn’t anywhere near collapse. But it does run a real risk of repeating many of the mistakes Japan made in the early 1990s.

The basic issue is that corporate debt is rising very fast, and the ability of companies to repay that debt is deteriorating, because much of this debt is going to finance projects that don’t deliver much of a return. At the moment, and for the next couple of years, China’s banks have enough funds at their disposal to keep rolling over the debts companies can’t repay. But at a certain point, banks will have to call time, and that point companies will have to stop accumulating debt and start paying it down, or deleveraging.

When companies start to pay down debt en masse, it’s bad for economic growth, because they cut back their investments. The government can keep economic growth afloat by borrowing more to finance investments in infrastructure: in other words, the decline in corporate debt can be offset (at least to some extent) by an increase in public debt.

This solution works best when the long-run return on public infrastructure investment is very high. Examples include the Great Depression in the United States and the late 1990s and early 2000s in China. In both cases, national infrastructure was very incomplete. So public investments in better roads and power grids, for instance, paid big dividends by enabling a lot more private business activity to spring up.

This solution does not work so well when the national infrastructure is already is good shape, meaning that building the next mile of road or the next power plant doesn’t do that much to improve the business environment for private companies.

This is the situation Japan got into in the early 1990s. Its companies had built up huge debt to finance investment in stock-market and property assets that proved astronomically over-valued. (Famously, the land under the Imperial Palace in Tokyo was said to be worth more than the state of California by 1990.) When land and stock prices collapsed by three-quarters after 1990, companies frantically started paying down debt. The government responded by borrowing more to finance infrastructure spending, but because Japan was already so well-endowed, the new infrastructure spending did little to generate new long-term growth. As a result, economic growth ground to a halt, and the country’s debt burden just grew higher. Japan got stuck in a low-growth, high-debt trap.

China isn’t quite at the point that Japan reached in 1990, but it is getting close. Its gross corporate debt level, at 160% of GDP, is among the highest in the world, and growing fast. China has invested so much in infrastructure over the past 15 years that new public investments there will yield little return. The low-growth, high-debt trap beckons.

The solution, in China today as in Japan of the 1990s, is to undertake structural and market reforms to boost productivity. Japan could have deregulated its service sectors and opened its doors to more private investment. China can dismantle some of its enormous and inefficient state owned enterprises, and deregulate service markets to promote more private-sector competition.

Japan did not make the necessary reforms, because to do so would have upset the cozy relationships between government and big business, and reduced bureaucrats’ ability to guide the economy, has they had done so actively (and successfully) in the four decades after World War II. China seems reluctant to make the necessary reforms, because this would involve greatly reducing the role of the state enterprises, and curtailing the ability of Beijing’s bureaucrats to manage the markets.

This is a complicated issue, because for every striking similarity between today’s China and 1990s Japan, you can easily find an equally striking difference. I’ll explore the details in future posts. But the risk is definitely worth pondering.